) -- The short sellers are getting squeezed right now -- in a big way.
In case you're not familiar with the term, a "short squeeze" is the buying frenzy that ensues when a heavily shorted stock starts to look attractive again to investors, causing share price to skyrocket. To exit their positions, short sellers have to buy back the stock they're betting against, adding extra buying pressure and forcing other short sellers out as well.
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How high can a heavily shorted, hated stock get squeezed?
Well, electric car maker
) is up more than 50% since Thursday, after better-than-expected profits sent short sellers covering their positions
) is up around 20% over the same time for similar reasons.
And while those high-profile names have been catching the headlines lately, my research shows that some of the biggest returns come from buying the most valuable stocks on investors' hate lists.
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When I say that investors "hate" a stock, I'm talking about its short interest. A stock with a high level of shorting indicates that there are a lot of people willing to bet on a decline in its share price -- and not many willing to buy. One of the best indicators of just how high a short-squeezed stock could go is the short interest ratio, which estimates the number of days it would take for short-sellers to cover their positions. The higher the short ratio, the higher the potential profits when the shorts get squeezed.
Going back over the last decade, buying heavily shorted large- and mid-cap stocks (the top two quartiles of all shortable stocks by market capitalization) would have beaten the S&P 500 by 9.28% each and every year. That's some material outperformance during a decade when decent returns were very hard to come by.
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It's worth noting, though, that market cap matters a lot. Short sellers tend to be right about smaller names, with micro-caps delivering negative returns when the same method was used.
Today, we'll replicate the most lucrative side of this strategy with a look at
five big-name stocks
that short sellers are piled into right now. These stocks could be prime candidates for a short squeeze in 2013.
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